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Chapter 2

Chapter 2. Financial Statements and Analysis. The Four Key Financial Statements: The Income Statement. The income statement provides a financial summary of a company’s operating results during a specified period.

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Chapter 2

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  1. Chapter 2 Financial Statements and Analysis

  2. The Four Key Financial Statements: The Income Statement • The income statement provides a financial summary of a company’s operating results during a specified period. • Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

  3. The Four Key Financial Statements

  4. The Four Key Financial Statements: The Balance Sheet • The balance sheet presents a summary of a firm’s financial position at a given point in time. • Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

  5. The Four Key Financial Statements

  6. The Four Key Financial Statements (cont.)

  7. The Four Key Financial Statements: Statement of Retained Earnings • The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

  8. The Four Key Financial Statements

  9. The Four Key Financial Statements: Statement of Cash Flows • The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. • This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

  10. The Four Key Financial Statements

  11. Using Financial Ratios: Interested Parties • Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial conditionand performance. • It is of interest to shareholders, creditors, and the firm’s own management.

  12. Using Financial Ratios: Types of Ratio Comparisons • Trend or time-series analysis • Used to evaluate a firm’s performanceover time

  13. Using Financial Ratios: Types of Ratio Comparisons (cont.) • Trend or time-series analysis • Cross-sectional analysis • Used to compare different firms at the same point in time

  14. Using Financial Ratios: Types of Ratio Comparisons (cont.) • Trend or time-series analysis • Cross-sectional analysis • Industry comparative analysis • One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance

  15. Using Financial Ratios: Types of Ratio Comparisons (cont.) • Trend or time-series analysis • Cross-sectional analysis • Benchmarking • A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate

  16. Using Financial Ratios: Types of Ratio Comparisons (cont.) • Trend or time-series analysis • Cross-sectional analysis • Combined Analysis • Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

  17. Using Financial Ratios: Types of Ratio Comparisons (cont.)

  18. Using Financial Ratios: Types of Ratio Comparisons (cont.)

  19. Using Financial Ratios: Cautions for Doing Ratio Analysis • Ratios must be considered together; a single ratio by itself means relatively little. • Financial statements that are being compared should be dated at the same point in time. • Use audited financial statements when possible. • The financial data being compared should have been developed in the same way. • Be wary of inflation distortions.

  20. Ratio Analysis Example • We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.

  21. Ratio Analysis • Liquidity Ratios • Current Ratio Current ratio = total current assets total current liabilities Current ratio = $1,233,000 = 1.97 $620,000

  22. Ratio Analysis (cont.) • Liquidity Ratios • Current Ratio • Quick Ratio Quick ratio = Total Current Assets - Inventory total current liabilities Quick ratio = $1,233,000 - $289,000 = 1.51 $620,000

  23. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Inventory Turnover Inventory Turnover = Cost of Goods Sold Inventory Inventory Turnover = $2,088,000 = 7.2 $289,000

  24. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Average Age of Inventory Average Age of Inventory = 365 Inventory Turnover Inventory Turnover = 365 = 50.7 days 7.2

  25. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Average Collection Period ACP = Accounts Receivable Net Sales/365 ACP = $503,000 = 59.7 days $3,074,000/365

  26. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Average Payment Period APP = Accounts Payable Annual Purchases/365 APP = $382,000 = 95.4 days (.70 x $2,088,000)/365

  27. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Total Asset Turnover Total Asset Turnover = Net Sales Total Assets Total Asset Turnover = $3,074,000 = .85 $3,597,000

  28. Ratio Analysis (cont.) Insert Table 2.6 here

  29. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Financial Leverage Ratios • Debt Ratio Debt Ratio = Total Liabilities/Total Assets Debt Ratio = $1,643,000/$3,597,000 = 45.7%

  30. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Times Interest Earned Ratio Times Interest Earned = EBIT/Interest Times Interest Earned = $418,000/$93,000 = 4.5

  31. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Fixed-Payment coverage Ratio (FPCR) FPCR = EBIT + Lease Payments Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]} FPCR = $418,000 + $35,000 = 1.9 $93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

  32. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Common-Size Income Statements

  33. Ratio Analysis (cont.)

  34. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Gross Profit Margin GPM = Gross Profit/Net Sales GPM = $986,000/$3,074,000 = 32.1%

  35. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Operating Profit Margin (OPM) OPM = EBIT/Net Sales OPM = $418,000/$3,074,000 = 13.6%

  36. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Net Profit Margin (NPM) NPM = Earnings Available to Common StockholdersSales NPM = $221,000/$3,074,000 = 7.2%

  37. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Earnings Per Share (EPS) EPS = Earnings Available to Common Stockholders Number of Shares Outstanding EPS = $221,000/76,262 = $2.90

  38. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Return on Total Assets (ROA) ROA = Earnings Available to Common StockholdersTotal Assets ROA = $221,000/$3,597,000 = 6.1%

  39. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Return on Equity (ROE) ROE = Earnings Available to Common StockholdersTotal Equity ROE = $221,000/$1,754,000 = 12.6%

  40. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Market Ratios • Price Earnings (P/E) Ratio P/E = Market Price Per Share of Common Stock Earnings Per Share P/E = $32.25/$2.90 = 11.1

  41. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Market Ratios • Market/Book (M/B) Ratio BV/Share = Common Stock Equity Number of Shares of Common Stock BV/Share = $1,754,000/72,262 = $23.00

  42. Ratio Analysis (cont.) • Liquidity Ratios • Activity Ratios • Leverage Ratios • Profitability Ratios • Market Ratios • Market/Book (M/B) Ratio M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock M/B Ratio = $32.25/$23.00 = 1.40

  43. Summarizing All Ratios

  44. Summarizing All Ratios (cont.)

  45. Summarizing All Ratios (cont.)

  46. Summarizing All Ratios (cont.)

  47. DuPont System of Analysis • The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. • It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below and in Figure 2.2 on the following slide.

  48. DuPont System of Analysis(cont.)

  49. Modified DuPont Formula • The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

  50. Modified DuPont Formula • Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return. • Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields: ROE = 6.1% X 2.06 = 12.6%

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